An introduction to the active-passive framework

Both active and passive can play a role in an investor portfolio. It really depends on their attitude towards risk and what they are trying to achieve. Index funds, which we also call passive funds or trackers, they really allow investors to get an exposure to the broader market, it could be an asset class, like global equities, or a sub-asset class, like emerging market credit, in a way that is cheap in the purest form, so in order to track a benchmark as close as possible. So it’s really low tracking error compared to a passive benchmark that they might be interested in. And that usually comes also with very tight relative returns and low costs. Active on the other hand gives the potential to investors to outperform the market through an alpha, so having an higher return compared to the benchmark, but also usually comes with higher dispersion in terms of outcomes, so additional risk, and they also tend to be more expensive than index funds.

The active passive framework is really a methodology that we identified at Vanguard in order to help investors to figure out how they should consider active strategies, so active exposures in multi-asset portfolios along with passive funds. And really it focuses on four key criteria, four key levers that investors should be aware of when they want to blend active with passive.

The first aspect, the first key lever is, well the expected alpha, so the expected level of outperformance that investors would expect from a specific active manager or active strategy. The second one is the level of costs associated with getting that active exposure, so how much more are they expecting to pay in terms of fees for having that specific active strategy in their portfolio?

The third one, associated with the alpha, is the level of active risk embedded with that portfolio manager, so how much more risk would the active portfolio manager bring into the portfolios by trying to outperform the market? And last but not least, is the level of active risk tolerance that an investor is willing to take into the portfolio. Now the active passive framework really is constructed around the broader framework for strategic asset allocation at Vanguard and really helps investors to identify how they should blend active with passive along with asset class and sub asset class exposures in a way that is consistent and identify what is the perfect blend for them at the same time, so simultaneously and on a consistent basis. The way that it differs a little bit from other approaches, more traditional approaches, is that normally you would identify the strategic asset allocation, so the perfect equity bond mix and the sub asset class exposures, first, and then you will try to map that asset class exposures with specific active managers.

What the active passive framework does is actually doing all of that at once in one step.